Market Risk

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Market Risk

• Rob Theller

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My Background (Or, why would Ward be silly
enough to invite me here?)

• Army - 19 Years
• Juris Doctorate
• MBA
• 17 Years with the Treasurer of Ohio
• 4 Years with Treasurer of Franklin County
• Chief Investment Officer
• Currently Teach BF726 here at OSU
• Absolutely none of which impresses my kids ?

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Market Risk

• Arises when FIs take positions and speculate
  about the value of securities, currencies and
  derivatives

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DEAR or VAR

• is a method of assessing overall institutional
  risks - Risk Metrics
• DEARMkt Value X Price Sensitivity X Potential
  adverse Move in Yield
• VAR DEAR X Square Root of N
• N of days held
• A good example is at www.contingencyanalysis.com

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On Balance Sheet Risk

• On balance sheet activities are current primary
  claims (assets) or current secondary claims
  (liabilities).
• The normal stuff

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Off Balance Sheet Risk

• Off balance sheet assets and liabilities have
  grown so much that ignoring them may generate a
  significantly misleading picture about the value
  of stockholders equity.
• Net worth should be measured as
• NW MVAssetsOn MVLiabilitiesOn MVAssetsOff
  MVLiabilitiesOff
• where MV stands for market value of the given
  category.

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Monte Carlo Simulation

• Allows you to overcome the problems of limited
  actual observations.
• By calculating the historic variance covariance
  matrix.
• Then decomposing that into two symmetric
  matrices.
• 10,000 random values of Z are drawn
• The VAR is the 500th worst simulated loss out of
  the 10,000
• See J.P.Morgan, Risk Metrics 1997

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Historic or Back simulation

• With Risk Metrics you assume a normal
  distribution ????
• Options and bonds show this is questionable.
• The large majority of FI use history to simulate
  in their models.
• Basic Use Todays Mkt Value, then apply historic
  changes that ACTUALLY occurred.
• Simple - No Assuming - No Stan Dev.
• This is what I use.
• (Remember Governments are VERY conservative)
• Start with HISTORIC CASH FLOW

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Market moves that you think are coming

• Forwards Contracts
• Future Contracts

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Economic Assumptions

• To prevent Market Risk surprises as much as
  possible
• Use some form of Analysis based on current
  assumptions
• I typically start by using the ECO Median
  projections from the major Brokerage houses.

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My Portfolio Strategy is derived from that

• When the yield curve STEEPENS (short rates go
  down long rates go up), THE BULLET OUTPERFORMS
  THE BARBELL.
• When the yield curve FLATTENS (short rates go up
  long rates go down), the BARBELL OUTPERFORMS THE
  BULLET.
• When the yield curve has an equal chance of
  movement a ladder outperforms

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FPV

• For 90 annual payment coupon corporate bond,
  with rrr 10 maturing in n 6 years

• If this same bond has an actual market price of
  945, what is the Err?

Err 10.27
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PV is easier if you set up a table
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Duration

• The measure of just how boring the speaker is
  today.
• OR duration is just a number that we calculate
  based upon the PV cash flow characteristics of a
  bond, and calculating durations of bonds allows
  us to directly compare bonds of different coupons
  and maturities.
• the concept of duration, which is weighted
  average time to maturity allows you to directly
  estimate a bonds sensitivity to interest rate,
  or Market risk changes.

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Modified Duration

• modified duration always estimates bond prices as
  compared to their actual market prices.
• MD
• Duration / (1(market rate/2))

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Convexity

• Modified duration assumes that the relationship
  between bond price and the market rate is a
  straight line, and that that line will always lie
  below the actual curvilinear relationship.
• Convexity is simply curvature, and in this
  context, measures the curvilinear relationship
  between bond prices and interest rates for a
  given bond. When we use the concept of modified
  duration, we implicitly assume that this
  relationship is a straight line, which causes us
  to overestimate changes in bond prices.
• Convexity adjusts for this overestimation, and
  when used in conjunction with modified duration,
  gives us a more accurate measure of the change in
  bond prices given a certain change in market
  interest rates.

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Credit Analysis

• Financial Statements
• Trends
• Analyst recommendations
• Moodys SP

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Portfolios that Ive used this on

• Ohio Lottery Commission DPTF
• Ohio Treasury
• STAR Ohio
• Franklin County Treasury
• QUESTIONS?